There has been a shift in the pricing model
Tech firms have shown innovation when it comes to pricing their services.
Once upon a time a company would create a product or service, sell it to a customer and go looking for new customers. Tech companies did the same, some people may remember buying a CD or downloading Microsoft office for a one-off fee and the software was yours. There was a sense of ownership. In order to get the repeat business, firms had to make significant improvements in their software and convince you that it was worth spending hundreds of pounds/dollars again on the software. Often customers were reluctant as the old software did the job, so why spend more money?
There is a problem with this pricing model and that is there are a finite number of computers in the world and fixed number of customers who can afford the software at a high up-front cost. Once you have sold it to everybody who could afford it, there is little scope for new customers at least for a few years. This means uncertainty in Revenue or should we say almost a guaranteed dip in revenue? Investors want constant returns and in order for the company to continue investing in R&D it needs a steady stream of income.
Here comes the innovation in Pricing model and the birth of ARR (Average Recurring Revenue), also known as subscription service. Whilst it is not a new invention since subscription service has long existed, it is a new method of sustainable revenue. Like everything there are disadvantages too, which will be discussed later.
What are the benefits of subscription service?
There are advantages for both consumers and producer, let’s discuss consumers first.
Within consumers, there are two main types, that is individual users and business licenses.
1. Reduced barrier to usage- the monthly or annual subscription cost is significantly lower than the lump-sum investment required in a one-off fee model. This means that an individual no longer needs large sums up money. This is especially useful for user with lower incomes and freelancer starting their own business.
Businesses purchasing licenses in large numbers for their workforce also no longer need heavy upfront investment. This reduced their opportunity cost; that is the cost of borrowing money or forgoing other projects because money was needed to purchase software.
2. Both individual and businesses get access to the latest software. Producers constantly update their software so the end user always has the latest version with full functionality.
3. Bugs are fixed and security flaws are covered as soon as they are found.
4. Exit cost is reduced, if you don’t like the product, you can terminate it without incurring the full up-front cost. Although one could argue that you even previously software applications came with a trial period, therefore this point is redundant. The counter argument for which would be that it is always easy to make up your mind within the limited trial period of 14 or 30 days, furthermore, if the product is not keeping the pace with the market and there are better options available in say 6 months then they sunk cost is minimal.
Benefits to Producers
1. Producers can lock the customers in long contracts, e.g., minimum 2 years contract. Therefore, the monthly subscription is guaranteed even if the customer dislikes the product.
2. Producers get a steady stream of Income, which provides internal and external stability when investing in future R&D projects and keeping the shareholders satisfied.
3. Piracy is almost eliminated, since the software makes regular checks with the server to check authenticity. Therefore, users who previously obtained free illegal copies have now become paying customers. This adds a new Revenue stream from a user base who did use the product but did not pay for it. It also improves bottom line performance, since the cost of development is fixed, therefore both Gross and Net profit margins improve. Subsequently, it improves multiple other financial metrics such as Return on Capital Employed and Cost to Income ratio.
What are the disadvantages of subscription service?
1. Users are tied with the same provider until the contract expires
2. Users need regular internet access to validate and verify the subscription. Therefore, in regions with poor internet connectivity their work can easily be disrupted. Access to reliable internet is not only an issue in developing countries but even in the developed countries there are areas that remain disconnected or with poor connectivity.
3. User needs regular income to continue paying for subscriptions. Let’s take an example of an individual who has just lost their job, previously they had ownership of the software and could use as for as long as they liked but now their means of income is tied up behind a monthly fee.
Disadvantages to Producers
1. There is an opportunity cost, in return for the Annual Recurring Revenue security the producer has to forgo the large one-time fee. This lump-sum played an important role in bolstering the Balance sheet, the access to large amount of cash facilitated Capital Expenditure (Capex) whereas now the producer will have to raise the funds through either equity dilution or borrowing. They lose out in both options; one leads to loss of control and the other burdens your financial with a regular interest payment on the loan. This reduces the amount of cash available for R&D and if available it comes with the pressure to realise benefits quickly, which shackles the creativity of the functional teams. The finance team does not escape either, they need to demonstrate the value for money to investors.
Is there a third way of getting the pricing, right? Yes, there is, speak to us at London Mentors.
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